Supreme Court speaks to vendors about settling fraud claims against customers who later file bankruptcy
By Scott E. Blakeley

On occasion a customer may misrepresent its financial condition to obtain product on credit from a vendor. The vendor may have fraud claims should the customer fail to pay for the credit sale. To avoid the costs of litigation, the parties may agree to settle the dispute, with customer agreeing to pay over time on the delinquent account. But what happens should the customer file bankruptcy prior to paying off the delinquent account? Is the vendor's claim discharged in the bankruptcy, or rather, does the customer's claim (customer is a sole proprietor) survive the bankruptcy as it may be found nondischageable? Does the settlement agreement serve to waive the vendor's fraud claim? The U.S. Supreme Court recently considered this topic.

In Archer v. Warner, ___U.S.___ (2003), the owners (debtors) sold their business, but were later sued by the buyers (creditors), alleging fraudulent misrepresentation arising out of the sale. The parties eventually settled. The settlement agreement was part cash and part installments. The creditors signed releases discharging the debtors from all claims arising out of the litigation, other than the debt owing. The creditors brought a collection suit when the debtors defaulted on the first pay ment of the settlement agreement. While this suit was pending, the sellers filed a personal chapter 13 bankruptcy, which was converted to a chapter 7.

The sellers then brought a nondischargeable action in the bankruptcy court seeking the debt due under the original settlement agreement and promissory note ride through the bankruptcy. The creditors realleged the fraudulent misrepresentations arising out of the initial sale of corporate assets in the nondischargeable action. One of the debtors denied any misconduct and asserted the affirmative defense of settlement of the original state court suit. The bankruptcy court ruled in favor of the debtor finding that the settlement created a novation, substituting a contract debt which was dischargeable for the fraud claims which were not.

Elements Of A Nondischargeable Action

Should a debtor that files bankruptcy defraud a vendor, the vendor may be able to have its claim "ride through" bankruptcy. A vendor may also seek to have its particular debt to be ordered non-dischargeable, or object to the debtor's discharge, wherein all of the debtor's debts are ordered nondischargeable.

The most common causes of action to exclude particular debts from discharge are: (1) fraudulently incurred obligations; (2) fiduciary fraud and embezzlement; and (3) willful and malicious acts.

The nondischargeable provisions provide that the debtor must be an individual. Thus, if the vendor sold to a sole proprietorship, or holds a personal guarantee on a sale to a corporation, LLC or partnership, the vendor has a claim against an individual. There are no nondischargeable claims against a corporation, as the corporation is not entitled to a discharge in bankruptcy. If the vendor sold to a corporation, and the insider of the corporation filed bankruptcy, the vendor may still have a nondischargeable claim against the individual, but must establish an alter ego claim against the insider.

Where property is obtained by the debtor's false pretense, false representation or actual fraud such claim may be excepted from discharge. Under the fraud nondischargeable provision, the vendor may establish either oral or written fraud by the debtor. With the oral fraud, the vendor must establish fraud and its reasonable reliance on the debtor's representation. If the fraud is in writing, the vendor must establish that the false financial statement is materially misleading and the vendor reasonably relied on the false financial statement.

The vendor may also have its claim ride through bankruptcy where it can be established that the debtor defrauded the vendor while in a fiduciary capacity. The vendor may also have its claim ride through bankruptcy where the debtor committed a willful injury. Courts have found that where a debtor has converted a vendor's property, such as collateral subject to a purchase money security interest may result in a nondischargeable claim.

The U.S. Supreme Court Considers Nondischargeability

The matter was appealed to the U.S. Supreme Court, as there was a split in decisions with the circuit courts of appeals. One view is that a settlement agreement does not distinguish a dischargeability claim under section 523 of the Bankruptcy Code, while the other favors the basic principle of encouraging settlements by way of freedom to enter into settlement agreements.

A majority of the Supreme Court found that, although the settlement agreement and releases may have served as a new agreement, the creditors were not barred from establishing the settled debt arose out of a fraudulent transaction that is nondischargeable under the Bankruptcy Code. The Supreme Court relied on a prior ruling from this court (Brown v. Felsen) finding that the court could look behind the settlement for facts showing fraud in the original action. The Supreme Court's decision highlights the Bankruptcy Code's underpinning that a dishonest debtor is entitled to discharge his debts. The good news for the credit professional is that the Supreme Court suggests that if the parties seek to settle their dispute, including a dispute arising out of fraud, a specific provision waiving the fraud claim should be included. Otherwise, the Supreme Court is resistant to allow a debtor to change nature of the debt (fraud claim to contract claim, which is dischargeable in bankruptcy) through a settlement agreement.

Corporate Credit Executive
Reprinted by permission from Trade Vendor Quarterly, Fall 03